What is health insurance (good) for

Insuranceprovided by a government program is considered “public” in the same way thatgovernment-run schools are “public schools.” Conversely, insurance purchasedfrom a private health ins

What Is Health Insurance

(Good) For?

An Examination of Who Gets It, Who Pays for It, and How to Improve It

What Is Health Insurance (Good) For?

Department of Public Health

College of Education, Health, and Human

Sciences, University of Tennessee

Knoxville, TN, USA

ISBN 978-3-319-43795-8 ISBN 978-3-319-43796-5 (eBook)

DOI 10.1007/978-3-319-43796-5

Library of Congress Control Number: 2016947399

© Springer International Publishing Switzerland 2016

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University, which gave me the time, space, and resources I needed to complete this work.

I could only have written this book with an incredible amount of help from manysupportive people and institutions in my life My family provided me with anincredible amount of encouragement and faith, and was extremely patient in lis-tening to me talk about health insurance, and this book, at great length They alsotaught me how to survive, and to thrive, in an academic environment, and provided

me with a great deal of myfine education

This book is in many ways the capstone and extension of my doctoral programand dissertation work I received amazing training at the University of Pennsylvania,principally at Wharton I appreciate the resources the university devoted to mytraining Especially important were the guidance of my advisor and dissertationchair, Mark Pauly, along with my dissertation committee, Scott Harrington, GregNini, and Jessica Wachter, as well as Joanne Levy, the “den mother” for all thedoctoral students I also want to thank the Agency for Healthcare Research andQuality (AHRQ) for funding through a T32 training grant (5-T32-HS000009) andR36 dissertation grant (1-R36-HS018835-01)

Several colleagues also provided support in the development and writing of thisbook Juan Leon provided feedback on the idea and a number of early drafts RobField reviewed my proposal as well as sharing his experience with publishingacademic books Richard Derrig, Cassandra Cole, and Sandy Barth all providedexcellent feedback on my proposal Mohammadreza Hojat connected me withSpringer and helped me learn how to work with them The staff at Springerincluding Janet Kim and Christina Tuballes helped to shepherd my book throughthe proposal, contract, and publication process The administration at Jefferson,including David Nash, Caroline Golab, and David Glatter, helped me develop thebook from an idea to a reality, understand how to fit it into my busy academicschedule, and how to negotiate with the publisher for the best deal I could get

A number of books on writing and academic life were particularly useful.While I never met any of the authors, they all helped me immensely Paul Silvia’s

“How to write a lot” and William Germano’s “Getting it published” helped me getthe book written and published Robert Boice’s “Advice for new faculty members”

vii

facilitated my gradual approach to the book, which I wrote in “brief repeatedsessions” as he suggested C Wright Mills’ “The sociological imagination” showed

me how to take a social science approach to writing a book, layering each cessive piece of the manuscript one on top of the other until, somehow, it wassuddenly done

suc-Special praise is due to three special people who helped me“get it done.” JenWilson, the scientific editor at Jefferson helped me at every stage along the way,editing the proposal as well as every chapter of the book I, and the book, benefittedfrom her editorial perspective and ability to gently deliver constructive criticismalong the way Two of my friends, Bill and Victoria, were also important inencouraging me to finish, reading me the “riot act” as needed If not for them, Iwould probably still be writing Chap 2again, and again, and again Instead, thebook is complete, and I am glad for it Finally, while others deserve credit for helping

me, all errors and omissions are my sole responsibility as the author I will maintain alist of updates and corrections at my personal website,www.lieberthal.us

Part I The Importance of Health Insurance

1 Defining Health Insurance 3

1.1 Healthcare Finance 3

1.1.1 Defining Healthcare Finance 3

1.1.2 Demand and Supply of Healthcare Finance 6

1.1.3 The Subjectivity of Healthcare Finance 8

1.1.4 Alternative Forms of Healthcare Finance 11

1.2 The Growth of Health Insurance 12

1.2.1 Diverse Beginnings of Health Insurance 13

1.2.2 Policy and the Growth of Health Insurance 16

1.2.3 Professionalizing Health Insurance 19

1.3 The Health Insurance Literatures 20

1.3.1 Health Insurance Policy 20

1.3.2 Health Economics 22

1.3.3 Risk Management and Insurance 24

1.3.4 Health Services Research 26

References 29

2 Insuring Health Capital 33

2.1 The Economic Value of Health 33

2.1.1 Consuming and Investing in Health 33

2.1.2 Health Investments 35

2.1.3 The Health Capital Model 36

2.2 Risk Aversion and Health Risks 37

2.2.1 Changes in Health Capital 37

2.2.2 Valuing Health Capital 38

2.2.3 Health Risk Aversion 40

2.2.4 Health Insurance Choices 42

ix

2.3 Financial Intermediation of Healthcare Spending 44

2.3.1 Insuring Health Indirectly 44

2.3.2 Monetizing the Value of Health 46

2.3.3 Challenges in Monetizing Health Capital 47

2.3.4 Health Insurance Pricing 49

2.3.5 Scale and Scope in Third-Party Payment 51

References 53

3 The Scope of Health Insurance 55

3.1 Measuring the Degree of Protection 55

3.1.1 Defining Quantity 55

3.1.2 Measuring Quality 58

3.1.3 Determining Prices 62

3.2 Optimizing Health Insurance 63

3.2.1 Health Insurance Trade-offs 63

3.2.2 Optimal Health Insurance as a Benchmark 66

3.2.3 Determining the Optimal Policy 67

3.3 Constraints on the Scope of Insurance 70

3.3.1 Insurer Constraints 70

3.3.2 Asymmetry of Information 71

3.3.3 Moral Hazard 73

3.3.4 Adverse Selection 75

3.3.5 Other Economic Externalities 77

3.3.6 Irrationality of Consumers and Producers 80

References 81

Part II Health Insurance Markets 4 Demand for Health Insurance 87

4.1 Health Insurance Demand Functions 87

4.1.1 The Demand Side of Markets 87

4.1.2 Demand as a Function of Price 89

4.1.3 Constrained Willingness to Pay 91

4.1.4 Diminishing Marginal Benefit of Health Insurance 94

4.1.5 Different Types of Demand Functions 95

4.2 Individual Demand 96

4.2.1 Direct Purchase of Insurance 96

4.2.2 Explaining Individual Demand 98

4.2.3 The Services Individuals Purchase 100

4.3 Group Demand 102

4.3.1 Employer-Provided Coverage 103

4.3.2 Explaining Employer-Provided Coverage 105

4.3.3 Social Insurance 108

4.3.4 Explaining Social Insurance 110

References 113

5 Producing Health Insurance 117

5.1 Health Insurance Supply Functions 117

5.1.1 The Supply Side of Markets 117

5.1.2 Supply as a Function of Price 119

5.1.3 Production of Health Insurance 120

5.1.4 Bundling Versus Disintermediation 122

5.2 Health Insurance Companies 124

5.2.1 Organizational Forms 124

5.2.2 Markets for Health Insurance Companies 126

5.2.3 Diversity of Health Insurance Companies 127

5.2.4 Competition and Partnerships 129

5.3 Healthcare Providers as Insurers 130

5.3.1 Providers’ Provision of Financial Intermediation 130

5.3.2 Direct Contracting Versus Third-Party Payment 133

5.3.3 Features and Drawbacks of Provider-Supplied Insurance 135

5.4 Employers and Governments 136

5.4.1 Health Insurance as an Instrumental Good 136

5.4.2 Self-insurance by Governments and Employers 137

5.4.3 Features and Drawbacks of Self-insurance 140

References 142

6 Matching Supply and Demand 145

6.1 Equilibrium Health Insurance 145

6.1.1 Economics of Equilibrium 145

6.1.2 Optimality Under Equilibrium 148

6.1.3 Health Insurance Subsidies and Taxes 150

6.2 Health Insurance Choices 152

6.2.1 Individual Choices 152

6.2.2 Employer Choices 153

6.2.3 Government Choices 155

6.3 The Uninsured 158

6.3.1 Defining the Uninsured 158

6.3.2 Explaining the Uninsured 159

6.3.3 Alternatives to Health Insurance 162

6.3.4 Consequences of Uninsurance 164

References 168

Part III Health Insurance Policy 7 Group Purchasing 175

7.1 Group Pricing 175

7.1.1 Actuarially Fair Group Insurance 175

7.1.2 The Role of Community Rating 176

7.1.3 Taxation and Regulation Considerations 177

7.2 Outsourcing Versus Insourcing Decisions 179

7.2.1 Provider-Based Insourcing 179

7.2.2 Employers and Outsourcing 183

7.2.3 Governments, Outsourcing, and Insourcing 184

7.2.4 Healthcare Reimbursement as a Public Good 186

7.3 Growth in Public Group Insurance 188

7.3.1 New Public Programs—Pre-ACA 188

7.3.2 Non Policy-Based Shifts to Public Insurance 190

7.3.3 New Public Programs—The ACA 191

7.3.4 Public Group Insurance Internationally 194

References 197

8 The Role of Government 201

8.1 Second-Best Health Insurance 201

8.1.1 Beneficent Social Planner 201

8.1.2 Feasibility and Second-Best Solutions 203

8.1.3 Addressing Market Failures 206

8.2 Features and Limitations of Public Policy 208

8.2.1 Policy and Regulatory Tools 208

8.2.2 Measuring Crowd Out and Deadweight Loss 211

8.3 Health Insurance Policy Options 213

8.3.1 Universal Coverage 213

8.3.2 Single Payer Approaches 216

8.3.3 A Range of Policy Options 220

8.4 The Meaning of Public Health Insurance 224

8.4.1 Federal Group Purchasing 224

8.4.2 Diversity and Homogenization 227

References 229

9 Public Policy Choices 235

9.1 The Economics of Value 235

9.1.1 Defining Value 235

9.1.2 Variation in the Value of Health Insurance 238

9.1.3 Improving Value 239

9.2 Expansion and Reduction 242

9.2.1 Defining Expansion and Reduction 242

9.2.2 Value Through Expansion and Reduction 243

9.3 Ongoing Health Insurance Challenges 246

9.3.1 Analytic Challenges 246

9.3.2 The Limits of Health Insurance 247

9.3.3 Public Choices 252

9.4 The Future of Health Insurance 253

9.4.1 The Risk Management Menu 253

9.4.2 Health Insurance as an Entrée 255

9.4.3 Unpicked Fruit 257

9.4.4 Better Meals, Better Lives 258

References 260

Index 263

The Importance of Health Insurance

De fining Health Insurance

1.1 Healthcare Finance

1.1.1 De fining Healthcare Finance

Health insurance has become central to American life Healthcare is an enormousindustry in the United States, comprising nearly 20 % of the economy Most of thepayments for healthcare servicesflow through a health insurer, meaning that healthinsurers manage trillions of dollars in funds for healthcare spending (Keehan et al

2015) Health insurance is also a major part of the U.S political system, rating as atop issue in elections by voters across the political spectrum (Newport 2016) Inaddition, health insurance has an intensely personal aspect given the highly per-sonal nature of health Health insurers that deny payment for treatments are derided

as “greedy” (Moynihan 2009) Conversely, many health insurers advertise thebenefits of their products, which allow people to “live fearlessly” in the words ofone major health insurer (McClung2014)

Despite the role that health insurance plays in the economy, the healthcaresystem and the political system, it is also a deeply misunderstood product At itscore, health insurance is a“pass-through” entity akin to a gas station Just as mostpeople rely on a gas station to store gas and then sell it to them on demand, mostpeople may relate to health insurance as a card in their wallet to be used any timethey have a demand (or need) for healthcare Health insurance is also related tohealthcare in the same way that a mortgage is related to a person’s house—peoplederive satisfaction from living in their house, not paying the mortgage In the sameway, people derive satisfaction from being healthy, not paying their health insur-ance premiums And yet, health insurance allows people to afford the cost oftreatments they could never pay for on their own, just as mortgages allow people tolive in houses they could never afford to pay for all at once

The easiest way to define health insurance is to look at the health insurance plansthat individuals use to pay for care For example, many people in the United States

© Springer International Publishing Switzerland 2016

R.D Lieberthal, What Is Health Insurance (Good) For?,

DOI 10.1007/978-3-319-43796-5_1

3

receive health insurance through their employer, or through a spouse’s or parent’semployer In 2011, more than half (55.1 %) of individuals were covered by private,employer-provided health insurance, making employer-provided health insurancethe most common source of health insurance coverage in the country(DeNavas-Walt et al.2012) Others receive coverage from public (government-run)social insurance programs such as Medicare and Medicaid “In 2013, Medicarecovered 52.3 million people: 43.5 million aged 65 and older, and 8.8 milliondisabled” (The Boards of Trustees, Federal Hospital Insurance and FederalSupplementary Medical Insurance Trust Funds 2014).“Medicaid provided healthcare assistance for an estimated 58.9 million people on average in 2013 An esti-mated total of 72.5 million people, or about one of everyfive persons in the U.S.,were enrolled in Medicaid for at least one month in 2013” (CMS Office of theActuary 2014).1 There is also a third group of people who purchase insurancedirectly from a private health insurance company on the“nongroup” market.Use of the terms “public” versus “private” health insurance to distinguishbetween types of health insurance can be useful but also misleading Insuranceprovided by a government program is considered “public” in the same way thatgovernment-run schools are “public schools.” Conversely, insurance purchasedfrom a private health insurance company and employer-provided insurance areconsidered forms of“private” health insurance This distinguishes the householdand employers’ purchase of health insurance from the public (governmental) pur-chase Under this definition of health insurance, private sources accounted for63.9 % of coverage for those with insurance, and public plans cover the other36.1 % of the insured population (DeNavas-Walt et al.2012) This taxonomy canalso be misleading because there are several forms of governmental subsidy of, andintervention in, “private” health insurance Conversely, many “public” healthinsurance programs are administered by private health insurance companies orhealthcare providers (e.g., physicians and hospitals).

Examination of health insurance as a form of healthcarefinancing often focuses

on the flow of funds through health insurers For example, employer-providedhealth insurance is considered important in large part because of the scale ofemployer-provided health insurance Health insurance is often the most costly part

of an employer’s labor cost next to salaries (cash wages) As a result, employersface a trade-off between the employees’ demand for health insurance benefits, thedemand for other forms of cash and noncash compensation, and the desired profitlevel or cost of services provided Different types of employers may choose todevote different amounts to health insurance For example, health benefits were onaverage 8 % of the cost of employee compensation for private employers and 12 %

1 Note that these numbers do not include children enrolled in the Children ’s Health Insurance Program (CHIP) for children in households with income above Medicaid eligibility levels In addition, many individuals are eligible for both Medicare and Medicaid, so-called “dual eligible” individuals Finally, the count of Medicaid enrollees is an average because of the fact that indi- viduals can obtain Medicaid coverage and then lose such coverage due to failure to re-enroll or lose of eligibility.

of the cost of employee compensation for state and local governments on average as

of September of 2015 (Bureau of Labor Statistics2015)

When public health insurance is examined as a form of healthcarefinancing, thefocus also turns to theflow of funds through government budgets Government atall levels has a large demand for health insurance, with plans that include Medicareand Medicaid, as well as coverage for current members of the military, theirfamilies, and veterans’ coverage The cost of health insurance makes the cost ofthese programs a major public policy concern Health insurance is one of the topthree highest costing programs for many governments at the federal, state, and locallevel For example, 24 % of the federal government budget is spent on Medicare,Medicaid, the Children’s Health Insurance Program (CHIP), and Affordable CareAct health insurance exchange (marketplace) subsidies (The Center on Budget andPolicy Priorities2015) This proportion of government spending equals the amountspent on Social Security and yet still does not include the amounts spent on gov-ernment benefits paid to employees of the government In this sense, federalfinancial policy is in many ways a debate about federal health insurance policy.Examining the cost of employer and government-provided insurance is com-plicated because both groups act as consumers and producers of health insuranceservices Both employers and the government purchase health insurance services.Since many employers and governments are also suppliers of health insurance, theycould be considered as health insurers For example, many employers run

“self-insured” health plans where the employer is responsible for risk management,while a health insurance company is responsible for administration (third-partypayment) Similarly, federal and state governments often choose to contract out(outsource) some or all health insurance functions to health insurance companieswhile providing other health insurance services directly For example, the federalgovernment is“at risk” under the “traditional” Medicare program—it is responsiblefor the cost of healthcare rather than passing on the risk to a insurance company,2however, it outsources the management of Medicare payments to large healthinsurance companies that act as servicers for the Medicare program

This book explores the tension caused by the trade-off between control,responsibility, and efficiency when a third party finances healthcare costs such aswhen individuals have the majority of their healthcare paid for by a health insurer.Employers, governments, health insurance companies, and healthcare providers areconstantly exposed to this tension because risk is shared, and managed, by thesedifferent entities Taking on risk management or third-party payment creates tension

by giving an organization more control over healthcare payments in order to take onmore risk Conversely, outsourcing a health insurance service reduces risk, but itlessens control Splitting up responsibility for healthcarefinance among a number

of insurers may increase efficiency through gains to specialization or reduce

2 “Traditional Medicare” is the program as it was originally conceived Many Medicare ciaries are now enrolled in managed care plans run by private insurance companies ( “Medicare Advantage ” plans) where the health insurance company is “at risk” for individuals’ cost of care.

benefi-efficiency since outsourcing requires some oversight function One of the mainpurposes of this book is to highlight these trade-offs, and facilitate better choicesthat can improve health insurance functioning.

1.1.2 Demand and Supply of Healthcare Finance

From a flow of funds perspective, health insurance is currently the “third-partypayer” for the majority of healthcare in the United States In 2013, 12 % of pay-ments for healthcare were considered“out-of-pocket”, meaning they came directlyfrom a consumer and went directly to a provider, according to the Centers forMedicare and Medicaid Services (CMS) The remaining 88 % was paid by a thirdparty (i.e., by a source other than the individual treated or by someone in his or herhousehold) In addition, the share of out-of-pocket payments is projected to shrinkslightly to 10.0 % in 2024 (CMS) The importance of health insurance is not limited

to the United States: most other developed countries also use a form of nationalhealth insurance or a national health system to pay for the majority of care:“The 25wealthiest nations all now have some form of universal coverage (apart from theUSA, where political opposition remains strong, despite a recent supportiveSupreme Court decision)” (Rodin and de Ferranti2012).3

Measuring healthcare finance through out-of-pocket payment is importantbecause it touches upon one of the rationales that may motivate people to obtainhealth insurance, which is to reduce or eliminate the financial burden that isassociated with healthcare costs In this sense, health insurance is said to be an

“indirectly demanded” good In other words, most people do not place an intrinsicvalue on health insurance, but rather value it in the instrumental sense that it frees

upfinancial resources to spend on other consumption and allows them to managethe risk associated with large healthcare bills Most people could never afford costlysurgeries or cancer treatments, and many people are unable to pay the out-of-pocketcosts for many brand name drugs Indirect demand does not mean that there isanything “inferior” about health insurance The observation is, in fact, true forhealthcare itself—people do not directly demand healthcare, but rather health, andhealthcare is simply a means to an end (Grossman1972)

Health insurance is also important from the point of view of providers andindividuals because most healthcare providers and facilities accept health insurancefor the payment of healthcare costs It is difficult to generalize about an industry asdiverse as healthcare, which can range from single physician practices to large,integrated health systems The fact that 88 % of payments for healthcare are fromthird-party payment sources shows the ubiquity of healthcare insurance-financed

3 The international perspective, while important, is not the focus of this book While this book will consider health insurance in countries outside the U.S., it will focus on the U.S health insurance system It serves to highlight the types of health insurance arrangements that may be useful for the U.S to consider, such as in Chap 7

care at the macroeconomic level In addition, the increasing intensity and tication of medical technology increases the amount of the economy devoted tohealthcare and may increase the demand for health insurance to pay for higher costtechnologies Weisbrod (1991), highlighted this phenomenon in a seminal study:

sophis-“One mechanism through which technological change could foster increasedexpenditures on health care would be through its effect on the health care insurancesystem” (Weisbrod1991)

However, there is substantial heterogeneity at the microeconomic level in terms

of whether a particular individual will be able to gain access to a specific provider

or a specific healthcare service or to obtain such services at a particular level ofquality These questions about the “narrowness” of provider networks and the

“quality” of health plans are crucial to disentangling the potential effects of healthinsurance on health Answering these questions is a major emphasis of “healthservices research (HSR),” which is explored further in this chapter It is also asomewhat intangible feature of health insurance that is important when grouppurchasers consider the characteristics of different health insurance plans andtrade-offs among such characteristics in Chap.7 For now, it suffices to point outthat in the United States, health insurance is not a homogeneous service but rather aclass of services that are provided to different groups of people by differentorganizations

Health insurance provides a major service in terms of“risk management” forhealth related risks by virtue of the fact that it is a third-party payer Risk and riskmanagement will be the subject of Chap 2 A good way to summarize the riskmanagement function of health insurance is to consider the fact that third-partypayment can be the basis for risk management, but third-party payment alone is not

a sufficient condition for saying that a health insurer delivers risk management Totake an extreme example, a health insurer that pays all, or many, of the claimsrelated to an unforeseeable injury, such as falling down aflight of stairs, is alsoproviding risk management Conversely, there are other instances in whichthird-party payment does not result in any risk management For example, if ahealth insurer pooled people’s money to pay for an annual wellness visit andnegotiated the price for such visits with a group of providers, there would be no riskmanagement services at all The insurer would simply be responsible for collectingthe money, disbursing it as a third-party payer, and negotiating a favorable rate withproviders There is no risk involved if everyone is getting an annual wellness visit.The only“financing” element would be indirect payment of the third-party inter-mediating between the patient receiving the wellness visit and the physician paid toprovide it

This book explores health insurance as generally situated between these twoextreme examples Many forms of healthcare are risky because the probability thatthey occur is neither zero nor one In addition, many forms of healthcare spendingrelate to healthcare risks that are partly within a person’s control In other words,healthcare spending is often related to conditions where individual behavior canmitigate, if not eliminate, the risk, such as diabetes It is also possible in theory for ahealth insurer to provide risk management without any third-party payment—an

organization could calculate the risks a person is subject to, calculate the expectedhealthcare costs, and direct that person about how best to protect themselves againstthose risks through a combination of prevention, precautionary savings, andinsurance Such advisory roles are more common in other types offinancial servicesthan in healthcare; most health risks management is bundled with some kind ofthird-party payment system We will investigate why this might be by nextexamining the subjectivity of healthcarefinance.

1.1.3 The Subjectivity of Healthcare Finance

Health insurance is distinguished from other lines of insurance because it covershealth capital Health capital is an economic way of viewing health as a valuableasset that people possess Health insurance covers health capital in the sense thathealth insurance payouts are based on a person’s health state A person who suffers

an injury or illness, or who is in poor health, receives benefits from a health insurerbased on his or her state of health As a result,“writing” health insurance involvesanswering questions such as,“What is a human life worth?” (also known as the

“value of life” literature) and “What is the value of returning an individual to fullhealth?”4 These questions may seem philosophical while insurance is a moreobjective financial product Indeed, traditional models of insurance are financialbecause they conceive the effects of insurance as using money to make individualswhole for the risks that they face Insurance is based on“monetizing” the value oflosses suffered by individuals, so health insurance is based on putting a dollar value

on a person’s health, as well as on any health losses or gains he or she experiences.The challenge in writing health insurance is that the value of health capital ishighly subjective and personal The use and origin of the term“health capital” isitself at the core of the economics of health insurance, and is the subject of Chap.2

of this book It is certainly a common sense notion that the value of human life issubjective However, the subjectivity of value is not a strict impediment to eco-nomic analysis—for example, two different people may place different values on anitem such as a diamond ring The reason that the subjectivity of health capital ischallenging for economic analysis is that there is no market for human life Healthcannot be bought and sold like other products such as a diamond ring As a result,economists and insurers cannot use the“market value” or “replacement value” ofhuman life to price insurance the way other lines of insurance do

From a policy point of view, it is also the case that the United States has aparticularly individualistic set of policies with respect to health insurance In mostother developed countries, health insurance is universal, compulsory, or provided to

4 “Writing” insurance refers to the process of assessing risk, creating an insurance contract, selling that contract to individuals or organizations, and settling claims arising from the insurance contract.

all individuals by the government Furthermore, healthcare is considered a basichuman right in many countries such as Italy, where this right is written into theconstitution, and where the country’s constitutional commitment to healthcare as abasic right has one of the highest“intensity scores” in the world (Kinney and Clark

2004) In the United States, health insurance coverage is much more diverse, andstill not fully compulsory.5An individualistic approach to health insurance is alsosomewhat at odds with the public, group nature of health insurance—if health is anindividual concern, then how can an insurer pool individuals together for thepurposes of writing health insurance?

Health insurers address the subjectivity of health mainly by focusing on thepragmatic fact that health insurance pays for healthcare Payment for healthcareallows health insurance to be a common service akin to other lines of insurance,such as automobile insurance or homeowner’s insurance Individuals may place anidiosyncratic or personal valuation on their own health, but the healthcare productsand services people use to restore and maintain their health are defined as a com-modity For example, aflu shot is a healthcare commodity A visit with a physician

is also a type of healthcare commodity Most health insurance plans are set up on a

“benefits” basis, to pay for such well-defined services, whether a physicianencounter, a day of hospitalization, or a 30-day supply of a specific drug Insurancecan also be set up on an“indemnity” basis, where the insured individual receives acash payment in exchange for a given loss Life insurance is set up in this way.Currently, indemnity based health insurance plans are rare, confined to lines ofinsurance such as “critical illness” insurance where an individual gets a definedcash payment upon a diagnosis such as cancer (Pokorski1997) To the extent thathealth insurance can take the existence, and pricing, of these goods and services asgiven, it can elide the more philosophical questions of value that arise in the healthcapital literature Health insurance simply pays for, and manages the risk of, costlyhealthcare goods and services

This straightforward definition of health insurance as paying for healthcare canbecome difficult because the definition of healthcare is also, in some sense, sub-jective For example, even the “commodity” service of a 15 min visit with aphysician is not a standardized product Defining what is and is not “covered” byhealth insurance has often been defined through the expertise of physicians andother providers For example, a health insurer will pay for a 15 min visit with aphysician if that individual has a“medical need” and the physician has a medicaldegree and a license to practice medicine However, we can see that there are issues

of both subjectivity and control that arise from such a policy For example, howshould an insurance company define the “necessity” of the office visit in the firstplace?

5 The Affordable Care Act changed this aspect of the health insurance system by introducing several health insurance mandates for individuals and employers However, even this mandate does not apply to all individuals.

The issue of insurer control arises because a health insurer that writes a policybased on physician expertise leaves itself open to essentially unlimited exposurearising from physician discretion This can be seen in the history of health insur-ance, where “usual and customary” charges for care gave way to more defined,

“managed care,” payment models because of the cost control issues involved inhealth insurance, followed by “backlashes” where controls on health insurancecosts based on a reduction in choice are removed in response to pressure fromconsumers and healthcare producers (Mechanic 2004) As a result, the ability to

define the scope of services is itself a health insurance function related to, butdistinct from, the risk management function that insurers perform In addition, thesetwo services—defining the scope of services and paying for care—may be per-formed by a single insurer or split between multiple health insurers depending onthe market where health insurance is provided Thus, an understanding of healthinsurance requires an understanding of traditional insurance models, what consti-tutes healthcare, and how insurers define and measure healthcare services and theeffectiveness of healthcare

The subjectivity of health capital relates to a more general dilemma in insurance

of the asymmetric nature of information in insurance markets In general, insurancemarkets feature“asymmetric information” in the sense that the person who seeksinsurance and the insurer know different information about the probability of a loss

An individual seeking automobile insurance may know how good of a driver he orshe is, and an automobile insurer may not reveal how likely individuals with similarcharacteristics are to incur insured losses

Health insurance markets feature a similar asymmetric information situation Theasymmetry is compounded by the fact that much of the value that people place ontheir own health is subjective and internal Differences in information are importantfor health insurance because, if a person makes a claim for healthcare in order to berestored to a particular level of health, then the health insurer must rely, to someextent, on that individual’s self-reported health state We will see that informationasymmetry leads to concerns about the problems of“adverse selection,” especially

in Chap.3

Of course, providers of health insurance and providers of healthcare haveinformation that they may not share with consumers, giving them a different type ofinformational advantage compared to consumers Health insurers have expertise inthe average cost of care for populations and in the design of health plans, and thisexpertise is beyond the grasp of most individuals Providers have expertise in theclinical nature of healthcare, particularly in what treatments are appropriate andmight work best for a particular individual Again, this leads to an informationaladvantage both because of the time costs of learning such information (consumerscould in theory learn about medicine, but it would take time) and because of trulyprivate information that a provider may be unwilling or unable to share, such as his

or her honest assessment of how well a treatment is likely to work That naturallyleads to the question of whether health insurance is the best way tofinance manyforms of healthcare

1.1.4 Alternative Forms of Healthcare Finance

Health insurance is ultimately a third party, intermediating between an individualseeking care and the provider who must be paid for delivering that care As a result,health insurance has a“loading cost” above and beyond the cost of claims, which isthe cost to design and administer the insurance plan All health insurance producersincur some cost for the production of health insurance This cost must be paid bysomeone, which is generally whoever “pays for” the insurance The third-partynature of health insurance also leads to a time cost in terms of healthcarefinance,introducing a lag between when healthcare services are provided and when they arereimbursed This is part of the“finance” system provided by healthcare Again, anyproducer of insurance, must generate, apply, and validate a set of rules in order to runthe insurance plan; indeed, the creation of this“rulebook” is a major part of the valuecreated by health insurers Individuals may seek to avoid this cost in order to reducethe overall cost of healthcare and spend their money on other forms of consumption.One other aspect of health insurance that many individuals may wish to avoid isits publicness Health insurance is “public” in the original sense of the word ofbeing common or of the people: “Of or pertaining to the people as a whole; thatbelongs to, or concerns, the community or nation; common, national, popular”(Murray 1933) Some forms of health insurance are also public in the sense thatthey are run or financed by the government Other forms of health insurance arepublic in the sense that they are run orfinanced by an employer, who then has afinancial stake in the health of its employees This publicness of health insuranceconflicts with the essential nature of health as a private asset, perhaps the mostprivate asset anyone possesses This is not to deny that health does not have publicconsequences—quite the contrary, a person’s health is of some concern to his or herfamily and friends, employer, and to society (also known in economics as an

“externality” or “spill over”) Rather, it is the case that, once health insurance isinvolved, the insured will be forced to surrender some control over his or her healthand healthcare in order to utilize the insurance policy

Alternatives to health insurance include personal finance activities An vidual could accrue savings in order to pay for future healthcare costs that he or shemight incur Such “precautionary savings” are a key aspect of the literature oninsurance (Kazarosian 1997) Another alternative for individuals is preventativeactivity Again, prevention—along with mitigation of risks such as health risks—is

indi-a clindi-assicindi-al pindi-art of the insurindi-ance literindi-ature, since such prevention could be seen indi-asone of the main alternatives to purchasing insurance or as a complement toinsurance, making the decision of purchase of health insurance and prevention onethat is best modeled jointly (i.e., as a contemporaneous decision) (Nordquist and

Wu1976) Additional options would include loans tofinance healthcare costs that aperson cannot afford using his or her current savings One theme of the book is thatthe main advantage of personalfinance activities is their generally lower cost thanhealth insurance, while their main disadvantage is that negative health shocksgenerally correlate with negative income shocks In other words, spells of poor

health not only increase demand for healthcare, but they also limit an individual’sability to earn income to pay for healthcare.

Public health activities are an attractive alternative to health insurance since theycan achieve the outcomes of improved health at a relatively low cost per person.Public health interventions, such as improved sanitation, can achieve positive out-comes in terms of health for a large population at a relatively low average cost perperson because public health programs often have so-called“economies of scale”with highfixed costs but low variable costs, or “economies of scope” where the sameprogram can be delivered to a wide variety of individuals at the same price Forexample, while water treatment plants are costly to create and maintain, the cost issmall for adding one extra household to a sewer system In addition, the properties ofclean water are essentially the same for all individuals regardless of their personalcharacteristics Additionally, public health interventions have the advantage thatthey do not rely on the individual willingness or ability to pay for health The maindisadvantages of public health are that it cannot be tailored to an individual’s health

in the same way that healthcare can be, and therefore may be less efficient, and the

“deadweight loss” of taxes used to finance public health programs

The other reason to consider alternatives to health insurance is that many of theimprovements in human health in the United States and other developed anddeveloping countries have come from interventions outside the healthcare system.Victor Fuch’s classic study “Who Shall Live” examined, and pointed to, the role ofcultural and other factors in terms of the health of populations For example, those

in Utah were healthier than those in Nevada due to religious practice (Fuchs1974).Public health is often more responsible than medical interventions for majorreductions in mortality and morbidity than healthcare on average In contrast,healthcare may be more effective on the margin—a person suffering an acuteepisode such as a heart attack can be saved and brought back to health, when in thepast he or she would have died (Weisfeldt and Zieman2007)

Healthcare is therefore best considered as a high effectiveness, high cost forimproving health Identifying the individuals who benefit from healthcare at themargin is a costly process Health insurance is designed to address health risks on acase-by-case, or person-by-person, basis by financing healthcare Thus, healthinsurance is an important product that can address health risks, as well as the cost ofhealthcare, in concert with many other complementary goods—self-care, prevention,mitigation, and public health programs This complementarity will be important fordesigning policies to promote the optimal health insurance policies as a larger effort

to protect and improve human health that are the subject of Part III of this book

1.2 The Growth of Health Insurance

Having defined health insurance, we next investigate one of the most salient tures of health insurance—its growth over time Health insurance has grown in bothabsolute and relative terms In other words, health insurance is now a large and

fea-important part of a healthcare industry In addition, health insurersfinance a muchlarger proportion of healthcare than they did one hundred or evenfifty years ago.This section explores the growth in health insurance in order to describe the contextfor the current use of health insurance and future improvements to the healthinsurance system.

1.2.1 Diverse Beginnings of Health Insurance

Health insurance as we know it today originates partly in other lines of insurance.Early forms of health insurance include“accident and disability policies” sold byinsurance companies Accident and disability policies were introduced in the late1800s to pay for costs related to these hazards to human life and health Relatedinsurance policies included nursing care policies that paid for the cost of nurses tocare for individuals in their homes (Bluhm2007, p 1) These markets later liber-alized in the 1920s and 1930s, as coverage was extended to medical costs andeventually sold separately from disability income (DI) policies (Bluhm2007, p 2).These forms of health insurance foreshadow the modern health insurance company

“Cooperative societies” were an alternative to insurance companies that vided a large amount of what we would call insurance today outside of the formalinsurance sector These cooperative societies, also known as“mutual aid societies,”were an extremely popular form of insurance.“By 1920, over a third of the adultmale population received sickness, accidents, or death benefits through association

pro-in cooperative societies” (Gottlieb2007) These societies were less formal, munity level risk sharing arrangements formed by individuals with similar pro-fessions Gottlieb (2007), further elaborates on how these societies were able tofunction in the absence of the actuarial pricing that is generally considered thefoundation of insurer viability.“Cooperative societies developed strict disciplinaryrules to deal with informational asymmetries To mitigate adverse selection prob-lems, prospective members had to undergo medical examinations as well as

com-‘character investigations.’” (Gottlieb2007)

The early history of health insurance also includes employer-provided grouphealth insurance called“industrial sickness funds” that was provided to individualsworking for the same company.“Such funds, organized by workers through theiremployer or union, provided the rudiments of health insurance, principally con-sisting of paid sick leave, to a large minority of the industrial workforce of the latenineteenth and early twentieth centuries” (Murray 2007, p xi) These funds werethus industry specific in the same way as cooperative societies and benefitted fromthe backing of the sponsoring institution These early funds faced some of theproblems that cooperative societies faced in terms offinancial viability, and theyalso used medical examinations in order to qualify individuals for their plans.“Tomitigate the problems of moral hazard and adverse selection, sickness fundsimposed a variety of tests such as waiting periods for applicants and claimants andthe certification by a physician of a member’s claim” (Murray2007, p 13)

Many industrial sickness funds can be traced back to early railroad and otherindustry specific funds For example, railroad funds were the largest group ofsickness funds identified in a 1908 survey by the U.S Commission of Labor—therewere 31 such funds with 262,747 members (Murray2007, p 79) Occupation wasalso an important rating class for individual health insurance.“Companies classifythe insurable occupations into groups of about the same average claim cost andhave a scale of premium rates applicable to the various classes (Dickerson 1963,

p 467) Occupation rating also led to difficulties given that certain professions were

so risky as to be considered “uninsurable” “Certain occupations are considereduninsurable for individual insurance Such occupations as test pilot, steeplejack,sandhog, and the like are beyond the purview of ordinary policy forms” (Dickerson

1963, pp 466–467) These industrial sickness funds are the foundation for thepreponderance of employer-provided health insurance in the modern U.S healthinsurance system

Healthcare providers were also key in the early development of health insurance.Baylor Hospital in Dallas developed one of the first forms of “prepaid hospitalcoverage.” Baylor University Hospital enrolled schoolteachers in this plan “The

1250 schoolteachers were encouraged to prepay their hospital care at Baylor for 50cents a month In return, they were offered twenty-one days of semiprivate care(including the use of the operating room and various ancillary services—anesthetic,lab tests) in a twelve-month period” (Fein1986, p 11; Kimball1934) We can see

in this setup one of the early features of what is now called “managed care”: a

defined quantity of benefits from a specific provider in exchanged for a fixed permember per month (PMPM) payment The use of healthcare services rather than acash payment for illness is also known as the“service basis” for health insurance.The use of a specified provider also means that there is an important dimension interms of the quality of the health insurance coverage, since all care would bedelivered by Baylor University Hospital, meaning that the schoolteachers wereaccepting Baylor’s definition of the quality and scope of care

The fact that the Baylor plan delivered hospital benefits to those who becamesick and restricted services to a specific hospital led to controversy in the 1930sabout whether the hospitals were selling a form of prepaid services or were in fact ahealth insurance company that was unduly restricting the choices of members (Law

1974, p 7) The prepaid plan was certainly a form of health insurance in the sensethat it financed healthcare for the members of the plan In addition, the BaylorHospital model was later developed into the“Blue Cross” plans for hospitalizationcoverage as states set up laws to enable hospital service plans in the 1930s and1940s (Law1974, p 8) In 1933, the“Blue Cross Plan (was) organized in Newark,New Jersey This, thefirst Blue Cross plan covering hospital services, (was) orga-nized by the Hospital Association of Newark, New Jersey” (National InformationCenter on Health Services Research and Health Care Technology (NICHSR)2013).Thus, not only was the prepaid plan a form of health insurance, but it was part of thegenesis of one of the most important types of health insurance companies, the BlueCross and Blue Shield companies

The “Blue Shield” plans grew out of efforts to allow individuals to financephysician services at around the same time that the Blue Cross plans formed forhospital services.“In a successful effort to derail a proposed state health insuranceprogram, California physicians had developed an insurance program for physicians’services in 1939 Out of this program there grew what is now known as BlueShield” (Fein1986, p 27) We can see in the origins of the Blue Shield program thesame drivers as the Blue Cross programs.“Physicians saw the benefit to hospitals ofhospital insurance, and they too developed an insurance program It paid forin-hospital services by physicians, mostly surgery” (Freeborn and Pope 1994,

p 29) As with the Blue Cross insurance, it was providers rather than insurancecompanies that initially sponsored insurance for their services As with hospitalinsurance, Blue Shield coverage focused on what was then the most expensiveaspect of physician services—those performed in the hospital.6

One of the common features of early forms of health insurance is that manybundled risk management for health with third-party payment for healthcare Forexample, the Baylor hospital plan did not pay benefits to members in cash, butrather supplied in kind benefits in terms of hospital services The risk managementaspect of this program was the fact that it paid out only to people who became ill.The third-party payment aspect of the program was the fact that it paid out inhealthcare services rather than in cash, also known as“indemnity” based insurance.The same is true to an even greater extent for the Blue Shield programs, whichprovided healthcare benefits rather than cash payouts, and was organized to paythose benefits to a number of physicians, rather than hold a fund that would be used

at a specific facility “The Blue Cross commitment to the payment of servicebenefits to hospitals means, simply, that while commercial insurers generally paythe individual afixed dollar amount per day or period of hospitalization, and theindividual bears primary responsibility for the payment of the hospital bill, BlueCross gives the subscriber the assurance it will settle his bill with the hospital, withthe subscriber bearing responsibility only for the coinsurance, or deductible,specified in the policy” (Kotelchuck1976, p 87)

Risk management and third-party payment are the key to identifying these earlyforms of health insurance, since both include core competencies offinance Manyearly forms of health insurance offered a form of mutual protection against lossesthat were individual by“spreading the risk around” for a population Thus, thesehealth insurance plans were providing risk management to their members.Third-party payment arose from a desire of healthcare providers to convert a

“lumpy”, risky payment stream in terms of uncertain utilization of their servicesinto one that was more regular Converting a stream of payments into a lump sum orchanging the timing of such payments is the essential role offinance—these early

6 Hospital based physician services remain more expensive the same services performed on an outpatient basis i.e., of fice-based physician services (Medicare Payment Advisory Commission

2013 ) The difference is that, in the modern health economy, physicians can perform a wide array

of procedures and services in these non-hospital settings that are expensive enough to require some form of financing, i.e., health insurance.

forms of health insurance could be considered as “swaps”, “…a contractualagreement between two counterparties that agree to exchange streams of paymentover time” (Corb2012, p 3) While the risk management provided to teachers bythe Baylor prepaid plan could be seen as secondary purpose of the program—ifanything, the risk that was being managed was the risk of providers related to theuncertainty of income related to health—it was a key benefit of the prepaid plan.These early forms of health insurance, and the controversy over whether hospitalprepaid plans were really health insurance, foreshadowed a modern controversyregarding health insurance about whether prepaid healthcare plans with fairlycertain payouts are“really” health insurance, or if health insurance must include arisk management component.

1.2.2 Policy and the Growth of Health Insurance

While the genesis of employer-provided health insurance was in industrial sicknessfunds and occupation-rated health insurance, it was tax policy that solidified thelink between employment and health insurance One of the major macroeconomicdifficulties that the government faced during World War II was increased inflation.One of the policies that the federal government enacted in order to try to reduce this

inflation was wage and price controls As a result, companies competing forworkers tried tofind other ways to compensate employees, and employer-providedhealth insurance was one of the benefits that many employers chose to provide.According to Thomasson (2003),“…government policies in the 1940s and 1950sprovided significant incentives for the formation of employment-based insurancearrangements” (Thomasson2003)

An additional policy regarding the tax treatment of employer-sponsored healthinsurance linked employment with health insurance That initial tax-favorabletreatment of employer-provided health insurance raised the subsequent question ofwhether health insurance benefits were taxable as income on a permanent basis TheIRS ruled that employer-provided health insurance as a benefit was not taxable inthe 1954 (Thomasson 2003) This ruling made health insurance provided on agroup basis through an employer relatively more attractive to individuals than thesame insurance purchased directly from a health insurance company at the sameprice The reason is that insurance obtained through an employer is “purchased”indirectly with pre-tax dollars, whereas the insurance obtained through an insurancecompany is purchased directly with post-tax dollars.7 Employed individuals,

7 Stating that individuals “purchase” their health insurance from an employer is based on the assumption that, in the absence of health insurance bene fit, employers would instead pay employees in cash through higher income The question of the incidence of the cost of health insurance provided by an employer is a major focus of the economic literature on employee bene fits In essence, health economists ask whether an employee who receives a dollar in health insurance forgo a dollar in income (money wages) The standard answer from economic theory is

especially those facing high marginal tax rates, had, and continue to have, a majorincentive to obtain their insurance through an employer.

Employers who sought, and seek, to provide health insurance to their workers inresponse to policy and tax changes face a different set of incentives than providers

or health insurance companies While providers and health insurance companies areattempting transform an unpredictable event (i.e., illness) into a predictable stream

of revenue, employers are attempting to achieve human resources goals ofemploying individuals to work in their organization As a result, employers were,and are, generally more concerned about the cost of benefits, especially as they aim

to provide insurance at a cost that is palatable to their employees

The use of health insurance as a“means to an end” for employers often leads todifferent forms of health insurance than those offered by health insurance compa-nies and providers For instance, the rise of commercial insurers after W.W II was,

in part, a result of employer involvement in the health insurance market.Commercial insurers wrote insurance based on “experience rating,” meaning theconstruction of a“risk pool” or group of individuals who are expected to utilize asimilar amount of healthcare under a particular health insurance plan Blue Crossand Blue Shield companies were more likely to use“community rating,” which wasbased on charging individuals a rate based on the prevailing cost of care in the areawhere they lived This difference was eventually resolved in favor of increased use

of experience rating in general.“The adoption of experience rating was probablyinevitable if Blue Cross was to compete successfully with low cost insurers for thebusiness of the low risk customer The alternatives were to persuade low riskgroups that Blue Cross was so useful as an organization serving the entire com-munity that low risk customers should subsidize the costs of the higher risk groups

or offer a service so excellent that high risk groups could be subsidized without fatalcompetitive disadvantage” (Law1974, p 12)

While commercial health insurance companies coexisted, and continue tocoexist with, Blue Cross and Blue Shield insurers, the distinction became mootonce both types of insurers were using community rating Indeed, while many BlueCross and Blue Shield insurers continue to operate as not-for-profit entities, theylost many of their governmental privileges, such as their exemption from payingfederal income tax (PricewaterhouseCoopers2005) It is now a matter of govern-ment policy to determine the extent to which experience rating is allowed in healthinsurance markets and this makes public policy, rather than insurer policy, a majordeterminant of the price of insurance As a result, this book treats all healthinsurance companies as a group with a common primary purpose, which is theproduction and sale of health insurance Chapter5includes additional information

(Footnote 7 continued)

that yes, he or she does “As indicated in the previous chapter, there are strong logical arguments for the proposition that labor market-wide health bene fit cost changes fall almost entirely on workers ’ wages and not on firms’ profits” (Pauly 1997 , p 77) Pauly ( 1997 ), presents an extensive treatment of this question from an economic point of view.

on the diversity of health insurance companies, as well as information on theemployers that provide health insurance.

One other important milestone in the growth of health insurance was theintroduction and growth of many government-provided health insurance plans.Medicare and Medicaid, the first major forays into health insurance by the U.S.government, were initiated in 1965 as extensions of the Social Security Act.Medicare was designed to cover hospitalization and physician services for thoseaged 65 and over, while Medicaid was designed to“…increase access to care and toreduce the burden of out-of-pocket expenses for exceedingly poor people”(Weissman and Epstein 1994, p 10) These programs had elements in common,such as their ties to Social Security, and they are currently administered at thefederal level by a single administrative unit of the federal government, the CMS ofthe U.S Department of Health and Human Services (CMS)

While Medicare and Medicaid share a common birth, the programs differ in anumber of important ways Eligibility for Medicare was originally age based(although later expansions added other populations to Medicare), while eligibilityfor Medicaid has always been based on a combination of income, wealth, andhealth conditions Medicare was set up as a consistent program nationally—Part Acovered hospitalizations, and Part B covered physicians’ services Medicaid wasinitiated as a federal/state partnership program The federal government covers part

of the expense of Medicaid, while the state covers the remaining costs and takesresponsibility for administering the program As a result, the extent of Medicaidcoverage varies by state—Arizona was the last state to set up a Medicaid program,and did not do so until 1982 when they introduced the“Arizona Health Care CostContainment System (AHCCCS)” (Brecher 1984) This variation also leads todifferent proportions of individuals being covered by Medicaid in different states

“There is considerable variation by state in the income cut-off, in the make-up ofeligible families (e.g., single parents versus married with unemployed spouse), and

in whether the state covers medically needy persons” (Weissman and Epstein1994,

p 10)

The impetus for the Medicare program was the high cost of medical care forolder individuals and the difficulty they had obtaining coverage Older people onaverage had, and have, higher average healthcare costs than the general population(Lassman et al 2014) The population aged 65 and older tends to have much ahigher degree of“risk aversion,” which implies that they would value all forms ofinsurance more (Halek and Eisenhauer2001).8The existence of Medicare allowspeople aged 65 and over to pay for the substantial healthcare spending incurred onaverage by those (Alemayehu and Warner 2004) However, as a result of theintroduction of Medicare and Medicaid, the cost of healthcare went from being an

8 Interestingly, Halek and Eisenhauer ( 2001 ) find that risk aversion declines with age It is only with the inclusion of an additional binary variable for being age 65 or older that they find this particular result.

individual dilemma to a policy dilemma No single milestone caused the programs

to become more costly, but instead, the cost of the programs to the government hasbecome a growing concern:“As time passed, the growth of costs in Medicare andMedicaid became the dominant issue in federal health policy discussions” (Phelps

2003, p 397)

Medicare and Medicaid are also important examples of “social insurance”programs with distinct features and aims compared to private insurance plans.While health insurance companies, providers, and employers represent specificeconomic stakeholders, the government in effect represents all of society Medicarehas a more redistributive and political explanation that is not captured by thetraditional insurance motivations for risk aversion and maintenance of health cap-ital Medicare and Medicaid can be seen as offering a“safety net” with respect tohealthcare costs for large swaths of the population One major caveat to this view ofthese social insurance programs, however, is their limitations—neither Medicarenor Medicaid offers“full” protection against health risks, and neither is universal interms of covering the entire population In addition, to the extent that these programprotect individuals by taking on their health risks and paying for their healthcare,they can do so either directly providing services or by purchasing services fromprivate companies Direct versus indirect provision of a public good is a facet ofsocial insurance programs that this book explores as the question of “insourcingversus outsourcing.” In other words, to what extent should the government directlyprovide health insurance as a social benefit, and to what extent should it outsourcethe management of these programs to private organizations such as health insurancecompanies and providers?

1.2.3 Professionalizing Health Insurance

The “insourcing versus outsourcing” decision has become more important forgovernments and for employers as health insurance has become more profession-alized Historically, healthcare was an out-of-pocket expense for those individualswith health conditions Healthcare was once more like shopping for groceries orfilling a car with gasoline The consumption of healthcare was between the individualand the healthcare supplier Healthcare is now distinct from most consumer products

in that there is very little that an individual purchases directly Instead, healthinsurance has evolved to become the“third-party payer”—providing the funds forhealthcare services from premium payments or general tax revenues Third-partypayment refers to any situation orfinancing mechanism where the person receivinghealthcare services does not directly pay for those services The increased use ofhealth insurance required an increasing degree of sophistication in healthfinance thatwas beyond the grasp of individuals and of employers and governments who aimed

to provide health insurance to employees or citizens (respectively)

“Third-party payment” for healthcare became more common during the 20thcentury, starting in the 1930s Baylor hospital was one of thefirst organizations topilot a “prepaid” healthcare program in the 1930s (Fein 1986; Kimball 1934).Government policies, such as the introduction of Medicare and Medicaid and thetax exemption for employer-provided health insurance, encouraged the spread ofhealth insurance Afiner definition of third-party payment involves looking at boththe proportion of care that a person pays for and how the price is set Indeed, somethird-party payment transactions involve no direct payout by the third-party payer,such as the use of low cost antibiotics Even in those cases, the negotiated price ofthe drug involves the third-party payer in processing the drug claim, so any defi-nition of third-party payment includes price negotiation, price setting, and claimsprocessing, functions.

Throughout the book, a theme is that the scope of health insurance and ofhealthcare are inexorably tied together As healthcare became more sophisticated,and grew to encompass a wider array of goods and services, health insurance grew

tofinance these new goods and services or to manage financial risks associated withthe growth of new services The best example is coverage for prescription drugs,which was not a part of early health insurance plans, and only later became a majorpart of health insurance coverage For example, Medicare did not include coveragefor prescription drugs as a basic benefit until 2003 (Centers for Medicare andMedicaid Services2005) The same causal link may work in the other direction—the rise of health insurance may enable the healthcare system to introduce morecomplex, more costly interventions, by providing a built-in market andfinancingmechanism for new services as they are developed The growth in health insuranceand healthcare also stimulated growth in a number of academic disciplines thatsought to explain, and improve, these important aspects of the economy Theseliteratures—health insurance policy, health economics, risk management andinsurance (RMI), and HSR—are the subject of the final section of this chapter

1.3 The Health Insurance Literatures

1.3.1 Health Insurance Policy

The health insurance policy literature focuses on policies that include thetax-preferred nature of employer-provided health insurance, the enactment of socialinsurance programs, and the enactment of more recent laws, such as the AffordableCare Act Health insurance policy sits at the intersection of health policy andinsurance policy It is concerned with laws, regulations, and other rules that canpromote health for the population, with health insurance as the methodology forhealth promotion Health insurance policy is also concerned with the laws, regu-lations, and other rules that promote the proper use of insurance, whether private orsocial (public) insurance (Field2006, Chap 1)

The Affordable Care Act (ACA) is one of the best examples of the study andapplication of health insurance policy because the vast majority of the law’s effectscome through the U.S health insurance system Coverage of those previouslyuninsured individuals is achieved through the expansion of two health insuranceprograms: Medicaid and the private, nongroup market for health insurance.

A number of new regulations restrict the management of health insurance, includingprohibitions on using a person’s health to determine his or her insurance premiums(i.e.,“medical underwriting”) and on setting an upper limit for payouts under healthinsurance policies A mandate also penalizes individuals who fail to obtain healthinsurance and many employers that fail to offer it These mandates were motivated

by insurance policy literaturefindings that, in the absence of a mandate, tions on medical underwriting lead to health insurers refusing to participate inhealth insurance markets or individuals “adversely selecting” into coverage byobtaining coverage when they anticipate becoming sick or dropping coverageduring a year of good health

prohibi-Ultimately, this book aims to provide a practical, applied guide to improvinghealth insurance through the use of health insurance policy The book’s chaptersbuild upon each other, leading to prescriptions for health policy in thefinal chapter.First, the book explains and examines the motivation for individuals to seek healthinsurance and describes the scope of health insurance in broad terms in Chaps.2

and3 Then, the second section of the book takes an in-depth view of the demandand supply for health insurance, respectively, concluding with a description of howdemand and supply are matched in health insurance markets in Chaps.4–6 Healthinsurance policy is thefinal section of the book, and each of the final three chaptersfocuses on a different aspect of health insurance policy Chapter 7 examines theeconomic trade-offs made by “group purchasers” of health insurance Chapter 8

describes the increasing role of the government in providing shaping healthinsurance, motivating the need to take a public policy oriented view of healthinsurance Finally, Chap.9 discusses tangible policies that are available to poli-cymakers and others to improve health insurance

A secondary aim of this book is to bring together perspectives on the structure ofhealth insurance from the academic disciplines of health economics, RMI, and HSR

in order to inform health insurance policy All three disciplines are needed in order

to view health insurance policy fully Health economics provides themarket-oriented view of health insurance as paying for healthcare It also suggeststhe main objective of health insurance policy, which is to encourage health insur-ance when the costs of such insurance justify the benefits (also known as “opti-mization”, “efficiency”, or “cost-effectiveness”) RMI examines health insurance as

a form of insurance, allowing policymakers and insurers to optimize the use ofhealth insurance in terms of managing risk and paying for care HSR looks at healthinsurance from the point of view of effectiveness, i.e., outcomes The outcomes ofhealth insurance are central to understanding the subjective view of health capital,and to improve the value of health by targeting health insurance where it is mostvaluable Each of these disciplines is reviewed in greater detail below

1.3.2 Health Economics

In an economic model, a market arises or is designed to fulfill a demand for aparticular good or service.9A market consists of two sides—a demand side and asupply side A functioning market brings together, or matches, the demand side(consumers) and the supply side (producers) Economic models of markets look atthese two sides as coming to an implicit or explicit determination of how to allocateeconomic resources across the economy through the mechanism of price.Consumers and producers trade in order to achieve this allocation of economicresources The economic perspective puts demand and individuals as the consumer

at the core of any marketplace Health insurance is no different—consumers (i.e.,

“patients”) are ultimately on the demand side of the health insurance market,whether directly or indirectly The popularity of health insurance can be identifiedthrough widespread use of health insurance in the United States and the universalhealth insurance coverage systems implemented in most other developedcountries.10

Health insurance markets exist to match the demand for health insurance vices with the supply of such services In U.S health insurance markets, there areseveral different consumers on the demand side of the market One group of con-sumers is individuals who purchase health insurance in order to allay risks related totheir health In addition, employers and governments consume large amounts ofhealth insurance produced in the United States as described in Chap.4 In healthinsurance markets, there are several different producers on the supply side of themarket One group of producers is health insurance companies who sell healthinsurance plans as their main line of business In addition, employers, governments,and healthcare providers all provide forms of health insurance as described inChap.5

ser-Health insurance has a specific role in paying for risky, future healthcare costs.Individuals face a wide number of risks related to their health, and health insurancecan act as a financing mechanism both in terms of paying for healthcare andproviding risk management services However, it is also the case that people aredifferent—some are healthier than others, some people have a stronger preferencefor healthcare, and some people are less comfortable taking risks, also known astheir degree of“risk aversion.” This diversity raises important questions about howthe preferences and resources of different consumers and suppliers for thisfinancialproduct result in the health insurance contracts that we observe

Health insurance demand is generally modeled by economists as being indirectrather than direct Health insurance only has an instrumental value—it pays forhealthcare, which is itself an input into the production of health Health, in contrast,

9 A market can also be altered through regulation in order to serve particular social or political ends

or correct “market failures,” as discussed in Chaps 8 and 9

10 Excellent treatments of health insurance in an international context can be found in Organization for Economic Cooperation and Development (OECD 2013 , Chap 7 ).

has both an intrinsic and instrumental value People enjoy being healthy, and theyvalue the activities that they can engage in when they are healthy, such as spendingtime with friends and family and working in paid employment As a result, indi-viduals may be willing to forgo scarce resources in order to obtain health insurance,even though it provides them with no direct value.

The standard economic model for the“indirect choice” problem posed by healthinsurance is the principal–agent model A principal–agent model describes anyproblem where one person or organization undertakes costly action or pays someamount, but another person or organization derives the benefits from that action(Smith et al 1997) For example, when a person hires a lawyer to negotiate acontract for them, the lawyer undertakes costly action to negotiate the contract.However, it is the person with the contract who derives any of the benefits under thecontract As a result, the principal typically has to compensate the agent for his orher work, i.e., the client pays the lawyer However, economics recognizes that thesplit between the person doing the work and the person deriving the benefits canlead to an incentives problem where the agent does not act in the principal’s bestinterest If a lawyer is paid afixed fee for negotiating the contract, he or she mayhave an incentive tofinish the work quickly in order to get paid, even if the contract

is of a low quality from the principal’s point of view The principal–agent modelapplies to health insurance because of the third-party payer nature of healthinsurance—health insurers pay for care that is consumed by individuals Thus,economists worry that health insurers may not have incentive to act in the bestinterest of the insured individual

Health economic models also explain why and how markets might fail, and howpublic policy can address those market failures Market failure is an importantconcept in economics in general, and is a particularly important topic in healtheconomics The principal–agent model underlying health insurance implies onetype of potential market failure, which is when a health insurer acts in its own bestinterest rather than in the best interest of the insured individual The principal–agentproblem is exacerbated in health insurance by the subjective nature of heath capitaland healthcare effectiveness Individuals and health insurers may have particularforms of information that they choose not to share with each other, interfering withthe proper functioning of the insured–insurer relationship For example, an indi-vidual may choose not to reveal a particularly sensitive health condition to his orher health insurer, such as mental illness While the rationale for the individual is toavoid a higher health insurance premium, a person’s choice not to reveal healthconditions to his or her insurer may lead to insurers refusing to write insurance forsuch a population Conversely, the possibility that a health insurer may not act as aperfect agent for the insured individual may cause individuals to avoid purchasinghealth insurance The fact that health insurance does not get written at all forparticular populations (the“uninsured”) in both cases can be considered a type ofmarket failure The economics of this problem, also known as the “asymmetricinformation” problem, also bridges the health economic literature’s concern withhealth insurance and the RMI literature’s concern with the proper functioning ofhealth insurance markets

1.3.3 Risk Management and Insurance

RMI involves the functioning of insurance markets to help individuals manage anytype of risk Health is just one risk that people face—individuals also face riskswhen they drive (automobile insurance), when they own a house (homeownersinsurance), and when they provide professional services (malpractice insurance) As

a result, issues about whether asymmetric information interferes in the function ofhealth insurance markets are common to other insurance markets In automobileinsurance, an individual may choose not to reveal certain aspects of his or herdriving behavior In homeowner’s insurance, an individual may choose not toreveal aspects of how he or she manages his or her home, or its current condition

As with health insurance, property and casualty insurers and those who repairautomobiles and houses have some expertise that they may choose not to share withindividuals In this sense, the RMI literature is valuable because there are generalprinciples that apply to all forms of insurance, as well as generalizable insurancepolicy solutions for improving any form of insurance, including health insurance.Health insurance is ultimately a form of insurance since it protects a valuableasset: health capital, described in depth in Chap.2 In forms of property insurance,such as automobile insurance, the property that is insured is a tangible form of realproperty—the home In life insurance, the property that is being insured is intan-gible—it is, in some sense, the value of a person’s life Life insurance is able toelide difficult questions such as “what is a life worth?” by pre-specifying a dollaramount as a payout Similarly, health insurance policies in some sense“solve” theproblem of valuing human health, and life, by specifying the dollar amounts paidfor different healthcare services and health conditions

One important principal of insurance is that only valuable assets are insurable.There is a functional reason for this principle, which is that the foundation ofinsurance is actuarial “loss modeling,” which means determining the expectedfinancial claims that may be incurred under a policy (Klugman et al.2012) In asense, the purpose of insurance is to anticipate a loss that a person may face, andprovide a way for that person to be“made whole” if he or she does incur a loss If

an asset is not valuable, then there is nothing to insure from the perspective of aninsurer

One special case of this principal is the situation in which an asset is unique ornot replaceable—for example, an old family photograph While there is a longliterature on irreplaceable commodities, starting with Cook and Graham (1977),insurance is designed for a situation where an asset is both valuable and repairable

or replaceable A house can be repaired or, in an extreme case, replaced Similarly,health insurance pre-supposes that there is afinancial response to illness or injurythat can either make a person whole or restore health at least in part

While a number of general contractual principles apply to all forms of insurance,the application of these principles to health insurance is both important and chal-lenging The six principles of insurance, uberrimaefidei (i.e., “utmost good faith”),indemnity, subrogation, contribution, insurable interest, and proximate cause are

defined and explained in Table1.1 All apply to health insurance For example,contribution applies to the situation, common in health insurance, where a personhas multiple health insurance such as the“dual eligible” population that has bothMedicare and Medicaid insurance As another example, the principle of “indem-nity” is challenging because health insurers are often unable to restore an individual

to his or her state of health before an injury or illness occurred Finally, proximatecause refers to the situation where two hazards may be responsible for a loss.However, many illnesses, such as diabetes, are chronic conditions that result fromyears of individual behaviors, environmental and genetic factors, so it may bedifficult to determine the “proximate cause” of an individual’s diabetes

In general, the subjectivity of health makes health insurance challenging to thegeneral principles of insurance Many of the principles and concepts of insurancepresume some objective value for a loss This need not be true in all cases—forexample, the concept of “non-economic damages,” such as pain and suffering,certainly contain a subjective element (Richter et al.2014) In health, how can wesay what the “full value” of a loss is? That will challenge the application of theprinciples of indemnity, subrogation, and contribution Insurers may respond bylimiting the dollar payouts under a contract either within a year or over a lifetime.However, lifetime and annual limitations on payouts under an insurance policy shiftthe health risk back to an individual, and indeed was made illegal under the ACAsubject to certain caveats (Thrasher2013) As another example, what is the burden

of “utmost good faith” for something as subjective and personal as a person’shealth? This is not simply an issue of full disclosure—a person may be unable tounderstand or to express the value of being in various states of health either before

Table 1.1 Six principles for insurance

Insurance principle De finition

Uberrimae fidei (i.e.,

“utmost good faith”) “…a higher standard of disclosure from both parties than mostother contracts ” (Richter et al 2014 ) Indemnity Insurance should “make the insured whole” in the wake of a

loss, but should not enrich an individual through a payment in excess of the loss incurred (Parker 1999 )

Subrogation “…a substitution by which the insurer who has paid a loss

under a policy succeeds to any rights the insured may have against any other person who may be primarily responsible for the loss ” (King 1951 )

Contribution No insured loss should be insured for more than its total value;

each insurer should share equally in the loss rather than paying the full amount under the contract (Merkin and Steele 2013 ,

p 144) Insurable interest “…mark(s) a boundary between legitimate speculation and

insurance on the one hand, and potential harmful gambling on the other …” (Merkin and Steele 2013 , p 25)

Proximate cause The cause most immediate to a loss governs the determination

of which insurer is responsible for a given claim (Simon 1972 )

entering into an insurance contract, or after incurring a loss.11However, truthfullystating whether recovery has occurred is central to placing an end point on aninsurer’s involvement with an insured individual after a loss.

There are also a number of important actuarial and financial principles ofinsurance management One of the principles that underlie private insurance con-tracts is“mutuality.” Mutuality is the principle that, ultimately, an insurer is simply

a“pass-through” entity All losses are ultimately borne by the individuals in theinsurance scheme by paying their premiums (Eeckhoudt et al 2005, p 45) Incontrast, the principle of“solidarity” underlies social insurance, which is the “…sharing of losses according to some other scheme…” (Wilkie1997) Each of theseprinciples can be applied to health insurance Private (non-governmental) healthinsurers can be seen as stewards for the premium dollars paid by individuals Theyapply contractual limits to benefits payouts both as a matter of rule and in order toensure that funds are adequate to cover the claims for all individuals in a healthinsurance risk pool Public (governmental) health insurers can use a combination ofpremium payments, personalfinancial responsibility (i.e., copayments), and generaltax revenue to fund insurance payouts Social health insurance payouts are limitedonly by the government’s ability and willingness to pay for healthcare

Insurance also generally relies on underwriting for cost management.Underwriting can be defined as “…the selection of risks and of the terms on whichthey are to be insured” (Head 1968) Underwriting is important because it is thebasis of solvency and viable insurance contracts, with solvency being the propo-sition that, from the position of the insurance company,“The continuation of thefunction and existence of the company must be secured,” while from the point view

of insurance regulators,“The benefits of the claimants and policyholders must besecured” (Pentikäinen1967) These concerns trade-off with the concern of afford-ability and willingness to pay—can the consumer afford the insurance contract, and

is he or she willing and able to pay for it (Russell 1996)? Underwriting is lessrelevant for health insurance because it is not a feature of most health insurancemarkets—governments, employers, and providers do not use underwriting toexclude individuals from their health insurance plans, and underwriting by healthinsurance companies is no longer allowed in the nongroup market under the ACA

1.3.4 Health Services Research

Health insurance, like any form of insurance, is ultimately judged based on itseffectiveness in restoring a person after he or she suffers a loss However, health and

11 Indeed, there is an enormous literature in health economics that is devoted to the valuation of different states of health The “quality-adjusted life year (QALY)” is often used to express the value of different health states Methodologies such as time trade-off (TTO) and standard gamble (SG) are used to determine these values experimentally The use of these methods is beyond the scope of this text An excellent treatment can be found in Drummond et al ( 2005 ).

healthcare risk management insufficiently explain the use and structure of healthinsurance with respect to effectiveness When losses can easily be monetized, thishealth insurance effectiveness can be judged easily When losses, such as those tohealth, cannot easily be monetized, then it seems legitimate to judge the healthinsurer on how well it restores an individual to full health or the health state he orshe enjoyed before a loss Outcomes depend crucially both on the extent ofhealthcare technology and on individual characteristics relating to the effectiveness

of care for a given person and his or her ability to engage in self-care (also known

as“adherence”) (Horwitz and Horwitz1993) Examining the effectiveness of healthinsurance requires a study of the literature from thefield of HSR

HSR is the discipline that is concerned with the effectiveness and outcomes ofhealthcare as it is delivered by the healthcare system.“HSR is the multidisciplinaryfield of scientific investigation that studies how social factors, financing systems,organizational structures and processes, health technologies, and personal behaviorsaffect access to healthcare, the quality and cost of healthcare, and ultimately ourhealth and well-being Its research domains are individuals, families, organizations,institutions, communities, and populations” (Lohr and Steinwachs2002) HSR can

be thought of as a translational science that links the biological understanding ofhuman health and biomedical science of developing effective healthcare therapieswith the evidence on such therapies’ real world effectiveness

The rationale for the study of real world effectiveness is that health insurancefinances healthcare that is delivered by the U.S healthcare delivery system As thatsystem has grown more complex over time, the demonstrated efficacy of healthcare

in clinical trials and other research settings has tended to diverge from the actualeffectiveness of healthcare as it is delivered in many cases As a result, the question

of what works in healthcare to improve human health is an empirical question that

is often context specific—HSR examines healthcare within that context Given thathealth insurance is the main mechanism used to pay for healthcare, it is animportant area of study for HSR The focus in HSR on health insurance can be seen

in the definition of HSR referenced above—“finance” and “cost” are key aspects ofHSR, as are organization and management of healthcare and access to healthcare Inthis sense, health insurance could be seen as a topic of study for health servicesresearchers in and of itself, as well as being a potential mediator for the effec-tiveness of healthcare

Health insurance is an important part of HSR precisely because different bursement systems could provide very different economic incentives for care.Insurers can use these incentives to change the way they pay healthcare providers,and thus alter how providers deliver care For example, the“prospective paymentsystem (PPS)” developed by Medicare in the 1980s (see Chap 5) was used tochange provider reimbursement and, in turn, improve the healthcare efficiency.Medicare switched from paying for hospital care on the basis of the cost of care topaying afixed rate based on the condition and acuity of a patient’s condition Such

reim-a chreim-ange could provide incentives to reduce high cost, low effectiveness creim-are,thereby increasing the overall cost-effectiveness of health insurance

A substantial body of work within HSR has been devoted to the impact of healthinsurance on healthcare utilization, health outcomes, and the effectiveness of care.Much of this literature can be traced back to the “variations in care” literatureoriginated by Jack Wennberg and colleagues In a series of three papers, Wennbergand colleagues documented a pattern of healthcare delivery in Maine and Vermontwhereby surgical procedures, hospital admissions, and hospital performance allvaried substantially (Wennberg and Gittelsohn 1975; Wennberg et al 1975a,b).They illustrated a wide range of variation both within the state of Maine andbetween Maine and Vermont For example, “Relative to population size, 37 %more tonsillectomies are performed in Maine than in Vermont while 80 % morevaricose vein procedures are done in Vermont than in Maine.” These differenceshad substantialfinancial implications: “The nine procedures in the areas of highestincidence cost a total of $29.39 per capita The correspondingfigure for the lowincidence rates is $11.93, nearly a 2.5 fold difference” (Wennberg and Gittelsohn

1975) The variations in care literature suggested that while health insurers musttake these variations as given, improvements in health insurance may involvereducing unexplained variations in care by changing the way that care is paid for.HSR can also help examine the effectiveness of other healthcare financingmechanisms that compete with health insurance For example, insurance economicsoften focuses on precautionary savings, prevention, and mitigation as three riskmanagement mechanisms to avert or ameliorate losses HSR has examined theeffect of each of these factors in terms of improving health, either as a complement

to or a substitute for health insurance For example, personal wealth andnon-financial wealth in the form of education and social determinants of health canhave an important protective effect on health (Deaton2003) Remaining uninsured

is another “choice” that in some sense “competes” with health insurance In theUnited States, health insurance needs to be attractive enough, or affordable enough,for individuals to obtain it in comparison with the choice to remain uninsured and,potentially, pay the tax under the individual health insurance mandate In contrast,

“All OECD countries have universal (or quasi-universal) health coverage for a coreset of health services and goods, except Mexico and the United States”(Organization for Economic Cooperation and Development (OECD)2013, p 14)

A more extensive description of the uninsured population is provided in Chap.6ofthis book

There are also a number of other ways of paying for healthcare outside the healthinsurance system that are important in HSR Public health and publicly fundedproviders and facilities are two of the most important forms of non-health insurancebased public funding mechanisms for healthcare discussed as alternatives to healthinsurance in Chap.9 Public health resources may be allocated to improve health,while publicly funded community clinics may provide basic care and vaccines tomany individuals Historically, many hospitals were publicly funded, although thenumber of beds in government owned and operated hospitals has been declining(Hansmann 1996) This literature stands in contrast to the focus of the insuranceliterature on perils to private property, since there is little or no public funding

available for other insured hazards, such as damage to one’s automobile or one’shouse.12

The existence of public health and non-healthcare interventions to improvehealth challenge health insurance to justify its use of additional resources Publichealth and non-healthcare interventions improve health and are funded withoutusing health insurance In other words, if alternative mechanisms can promote morehealth at a lower price, then why fund or utilize health insurance? Answering thatquestion, and the more focused question of when to use health insurance, is thesubject of this book We begin the answer in the next chapter with an examination

of the asset being insured: health capital

Bureau of Labor Statistics (2015) Employer costs for employee compensation —September 2015 Washington, D.C.: U.S Department of Labor (No USDL-15-2329).

Centers for Medicare and Medicaid Services National health expenditure projections 2014 –2024 Washington, D.C.: Centers for Medicare and Medicaid Services Retrieved from https://www cms.gov/Research-Statistics-Data-and-Systems/Statistics-Trends-and-Reports/

DeNavas-Walt, C., Proctor, B D., & Smith, J C (2012) Income, poverty, and health insurance coverage in the United States: 2011 Washington, DC: U.S Government Printing Of fice (No P60-243).

Dickerson, O (1963) Health insurance Homewood, IL: Richard D Irwin Inc.

Drummond, M F., Sculper, M J., Torrance, G W., O ’Brien, B J., & Stoddart, G L (Eds.) (2005) Methods for the economic evaluation of health care programmes (3rd ed.) New York: Oxford University Press.

12 One counterexample is the case of flood insurance, where there is both a federally managed insurance program (the National Flood Insurance Program (NFIP)) and a strong interest in com- mon, public mitigation measures such as floodplain management that can reduce the frequency and severity of losses due to flooding (Michel-Kerjan and Kunreuther 2011 ).